5 Minute Tute: Crash!

It is not a complicated story of finance or economics, but a very human one – people driven by greed and reckless exuberance, who made choices they believed to be good ones but turned out to be bad. While every crash is unique – the human behaviour at the centre of them is almost always the same. Overproduction and saturation of new markets were lowering prices and threatening profits. The stock market had been rising throughout the 1920s, drawing in more investors and driving stock prices ever higher. Monetary policy was also lax, making cheap money readily available. Stock market prices had disconnected from other fundamentals such as property prices but speculation continued to inflate the bubble. Eventually there was a correction. Stock prices collapsed in October 1929 and continued declining thereafter.

What were its consequences?

In terms of the stock market, the results were profound. The Dow Jones Index lost over 90% of its value over the next three years and did not recover its 1929 level till the 1950s. In terms of the wider consequences,while the Crash and the Great Depression were correlated, a causal relationship is disputed. The direct consequences of the crash were bankruptcies, foreclosures and higher unemployment – diminished confidence and negative consumer sentiment. A lack of flexibility in the economy, credit constraints and banking failure, deflation,mass unemployment further lowered the productive capacity of the economy. Policy choices such as adherence to the gold standard and protectionism made matters much worse.

Why can’t we avoid these economic problems?

I would argue that two great crises in a century is not a bad record. In a globalised world, capital flows freely and markets have become more integrated. This means shocks are transmitted universally and quickly. Global imbalances have been created with excessive savings in Asia lowering interest rates, creating cheap money which feeds overconsumption in the west, creating distortions and forming bubbles in asset prices. This is an overarching problem though regulation can help curb excess. Also we know a lot more about dealing with crises and one reason we have avoided a repeat of the Great Depression is the different polices that have been employed – we didn’t make the same mistakes. There are plenty of lessons to be learned here too which might abate future crises.

Are we in a similar situation today?

The question is quite revealing – there is a general tendency to equate the stock market with overall economic performance or societal well being. So while the stock market did suffer significant declines last year, it has more or less recovered with the Dow recently passing 10,000. However this recovery is not shared by the overall economy where growth is anaemic in the US and Europe and has not returned to the UK as yet. The recovery of the stock market may be largely illusionary. When adjusted for inflation, lower dollar value, the stock market has not reached the heights of the dotcom bubble. In addition the recovery is driven by pumped up financial stocks (though mostly on the investment banking side, less so for retail banks) which have received enormous government bail-outs. Also with large multinationals deriving much of their wealth from overseas markets – it is not a reflection of recovering demand in Western markets. The robust performance has also been driven by cost savings from blue chip companies – less spending and less employment – so while this has been good for investors, it has not been good for the economy.

How worried should we be for our economy?

The world economy will do fine, but the distribution of growth may change. The ascendency of Asia seems to confirmed by the crisis as it has exited quickly and resumed its impressive growth led by India and China. Europe and the United States have undergone a transition in their economy over the last decades – manufacturing has all but disappeared. Services and consumption have filled the void, but there is only so much consumption that an economy can afford. The success of the financial sector seems to be rather artificial – a reflection of churn rather than innovation. Growth generated over the last ten years was probably due to increased liquidity, not increased productivity – most of this growth was simply not real – and brings into question how we measure economic performance. While the stock market has recovered, the underlying picture is not good – unemployment is rising, credit is still not freely available, corporate debt and government deficits are spiralling. As was the case in 1929, the financial economy can not be divorced from the real economy for long.

William Hynes is a researcher and analyst in Economics and Economic history based at Jesus College.